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A Legal Barrier to Higher Interest Rates

Defending the Federal Reserve’s recent decision to put off
raising interest rates again, Fed Chair Janet Yellentold reporters last week that she and other Fed
governors wanted “to see some continued progress”
before taking that step. Politics, she insisted, had nothing to do
with it.

What Ms. Yellen didn’t say is that the Fed couldn’t
raise its rates without breaking the law. Since when are Fed rate
increases illegal? Since the 2007-08 subprime meltdown and
financial disaster, actually.

Until then the Fed could set any target it liked for the
federal-funds rate—the interest rate banks pay for overnight
loans of cash reserves. To keep the fed-funds rate from rising
above target, the Fed pumped more reserves into the banking system.
To keep it from dropping below, it took reserves away.

But after Lehman Brothers failed in 2008, the Fed’s
efforts to keep the fed-funds rate from dropping below its target
proved futile. To set a floor on how far the rate could go, the Fed
started paying interest on banks’ reserve balances with the
Fed, taking advantage of the 2006 Financial Services Regulatory
Relief Act giving it permission to do so.

If the Federal Reserve
chooses to tighten monetary policy, it will have to do so
legally.

Alas, it didn’t work. Government-sponsored enterprises
Fannie Mae, Freddie Mac and the Federal Home Loan Banks, which also
kept deposit balances at the Fed but weren’t eligible for
interest on reserves (IOR), started making overnight loans to banks
at rates below the IOR rate. In effect, this turned what the Fed
hoped would be a floor on the fed-funds rate into a ceiling. To
raise rates now, the Fed increases the rate on reserves.

So what’s to keep the Fed from raising rates this way
again? The 2006 Financial Services Regulatory Relief Act is what.
For that law only allows the central bank to pay interest on
reserves “at a rate or rates not to exceed the general level
of short-term interest rates.”

The rub is that the Fed’s IOR rate of 50 basis points
(0.5%) already exceeds the closest comparable market rates: those
on shorter-term Treasury bills. At the start of this month, the
four-week T-bill rate was just 26 basis points; since then it has
slid even lower, all the way down to 10 basis points. Judging by
these numbers, the Fed is already flouting the law. Another hike
would mean flouting it all the more flagrantly. Lawmakers will be
duty-bound to object.

When Jeb Hensarling (R., Texas), chairman of the House Financial
Services Committee, grilled her earlier this year on this issue,
Ms. Yellen responded feebly that the difference between the
fed-funds rate and the IOR rate at the time—12 basis
points—was “really quite small.” That’s
rather like trying to avoid a speeding ticket by claiming to have
been speeding only a little bit. Pressed further, Ms. Yellen
insisted that, despite what she’d said earlier, the
Fed’s rate settings were “legal and consistent with the
[2006] act.”

The law can only be stretched so far. Unless “general
short-term rates” rise markedly, Congress can be expected to
question the legality of any Fed rate increase. If it comes to
that, Ms. Yellen will find it very hard to dissemble her way out of
it.

Has the Fed any other choice but to stand pat or risk an ugly
fight in Congress? It does. Instead of paying banks more to hoard
reserves, it can tighten money the old fashioned way: by selling
off some of its trillions of dollars in assets. Besides avoiding a
brush with the law, selling reserves would mean taking a genuine
step toward the “normalization” of policy that the Fed
has long promised. That normalization would eventually allow the
Fed to return to its older and more reliable—and perfectly
legal—means of monetary control.

Whether events will warrant tightening before the year is out is
anybody’s guess. But if the Fed chooses to tighten, it should
at least do it legally.